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Economics of Defense

The Royal Navy and Economies of Scale

I must go down to the sea again, to the lonely sea and the sky,
And all I ask is a tall ship and a star to steer her by.
And the wheels kick and the winds song and the white sail’s shaking,
And a grey mist on the sea’s face, and a grey dawn breaking.

-John Masefield

The concept of ECONOMIES OF SCALE is one familiar to any business owner who has attempted to compete with a larger, deeper pocketed competitor. Among the advantages for the larger party are a more sizable labor pool, a larger array of technologically superior machinery, and access to a greater supply network of raw materials. Over time, the cumulative advantages enjoyed by the larger competitor gradually branch out, deepen, and compound, overwhelming the smaller competitor’s ability to try and compete head on. The larger competitor amplifies its strengths in all key areas that its size will facilitate, from the higher quality labor pool it is able to attract, to the more rapid production enabled by its sophisticated machinery, to the fewer “bad” products it produces, given the quality assurance and quality control measures it can afford.

Most important of all however, and the central reason for pursuing an economy of scale, is the ability of a large manufacturer to churn out its product for a lower per unit cost. This is the point of separation that ultimately puts one’s competitors out of business, as they become unable to compete with a comparable product that costs less and less to produce and thus generates a higher profit margin for each unit sold. Despite this competitive advantage for the large manufacturer, it is nonetheless possible to drive one’s seemingly dominant business into the ground. This is due to the other total costs of running a larger scale operation, from the high payroll to the cost of investment in newer and better manufacturing equipment. This is no small concern. With just one failure to adapt to consumer preferences or market conditions, today’s economy of scale can be tomorrow’s massive and costly liability.

Notwithstanding this risk, when might it be prudent to restructure one’s existing organization in order to try and create an economy of scale where one does not currently exist? British economist and Pulitzer Prize winner Alfred Chandler succinctly addressed the logic of this proposition when he noted that “structure should follow strategy”, meaning one should only reconfigure one’s organization if by doing so it is able to more efficiently pursue the ends/ways/means calculus that gives an organization its purpose. For British naval strategists of the 19th Century, the question of whether to set about creating an economy of scale on the high seas was a vexing one indeed. The Royal Navy’s advantages were already significant. But, they wondered, could they become insurmountable for potential competitors should they assemble a fleet double the size of their two nearest competitors? The prevailing strategy of the Empire and its navy seemed to suggest its necessity, wherein “for the first time in history, the defence of the Empire was treated as a whole”, but would Britain’s finances allow it? Just as importantly, what would its potential adversaries do to stop it?

Economies of Scale on the High Seas, and When and How to Pursue Them

Britain’s Royal Navy (RN) was one clear winner of the Industrial Revolution, enjoying the distinct resourcing advantages that emanated from the British manufacturing juggernaut ashore. The reason is clear: as British advantages in manufacturing during the Revolution led to a further extension of its global economic power, the critical guarantor of that power, the RN, was naturally seen as an important area for investment. Britain’s reasons for redoubling its focus on the Navy in the 19th Century went beyond the obvious surface reason of merely protecting its merchant ships, for as Greg Kennedy points out, the RN was more like the potter’s wheel upon which British Empire’s overall fortunes were built:

The navy was a useful way for the government to redistribute money into the national economy; it provided economic security through the demands made on the nation for the upkeep of the navy, a navy which in rum ensured a steady flow of raw materials and access to markets throughout the empire; it provided a psychological deterrent to other nations who might desire to destabilize that imperial system; and finally it was a living experiment for the introduction and application of the new technologies issuing forth from Britain’s industrial revolution.

Thus, rolled up in the RN was a catalyst for spending, an underwriter of future stability, a reliable client for the nation, a means of distribution, an enforcer of monopoly, and an incubator for innovation. As it pulled farther away from its nearest competitors, these various roles underscored precisely why the RN’s entrenched position of advantage among global navies had become more pronounced over the decades. For some within the British elite, the period of relative calm in the mid to late 19th Century was the opportune time to calcify and systematically exploit that advantage.

Their logic was compelling. For a maritime power like the British, the tie between its economic and military levers was clear cut, as the symbiosis between the RN fleet and the economic fortunes of the British Empire had grown inextricable. As a maritime state, the new line of Mahanian thinking went, Britain had to secure the power it had amassed as a maritime nation by producing and manning a sufficient number of naval ships to protect its commercial supply lines so that it could afford to build more ships and further expand its influence.

Although this circular logic might lead one to wonder about the possibility of spending beyond the point of optimal return, a compelling economic counterpoint was put forth by George Hamilton, First Lord of the Admiralty, who noted before the House of Commons that through rapid and massive expansion the British navy would be “able to associate an increase of strength with a decrease of expenditure.” Imagine: Spending more to save more, all while investing in the very tool that made Britain so exceptional! Hamilton was understandably hooked on the dream of the RN achieving an economy of scale in its industry.

Hamilton’s thoughts on the way ahead didn’t stop there. He went on to say that in fact “it would be […] dangerous to pursue a course in naval warfare in which we should assume that all unprotected towns and commerce would be unmolested by an enemy.” This is a telling observation, as it suggests that Hamilton, as the chief advocate of the RN in Parliament, had become so absorbed by the notion of British dominance of its maritime competition that he had become correspondingly uninterested in the hard work of deciding where to assume risk, instead simply preferring to leave nothing undefended.

Despite this astonishing leap of faith, the Mahanian-monopolistic line of thinking that Hamilton represented finally became British policy in the form of the Defence Act of 1889, Britain’s landmark naval program that called for amassing a fleet equal in size to the combined fleets of its two nearest competitors over a period of five years. Publicly, the Act was easily sold as a prudent means of deterring potential adversaries like France and Russia, reworking the same strategic calculus echoed before and after by many of history’s empires. In practice, however, this massive build up quickly led to a set of unintended consequences and a poor return on Britain’s investment.

The Fallout and Its Ramifications

First, Russia, France, the United States, and Germany clamored to meet the unspoken challenge put forth by the British. Their concern soon translated into similar increases in naval spending, “increases so large and for such long periods in advance as to alter the complexion of the whole very materially.” Admittedly, while the British gambit at first compounded its numerical advantages on the high seas, it soon warped the state of affairs between the RN and its maritime competitors into a dynamic that was less than favorable for the RN. Instead of finding itself exploiting the advantages of an economy of scale, the RN was left to contend with more competition for dominance of the seas. How could this have happened? Economic theory would suggest that the power gap between the dominant outfit and its smaller competitors would become more pronounced as per unit (per ship) costs declined and efficiencies were maximized, right?

The disconnect between economy of scale theory and its application in the defense world lay in Britain’s poor reading of the security environment, combined with an unshakeable fixation on the advantages of lowering per unit costs relative to the diminishing returns they represented. Lord Hamilton was seemingly so absorbed with the idea that Britain could create a fleet so massive that no two powers could touch it that he failed to think realistically about the likelihood that those powers ever realistically would challenge the RN’s primacy. Furthermore, the efficiencies of increasing production, while tempting, had blinded him to the possibility that British production would quickly reach a point of diminishing returns, with each subsequent naval vessel actually guaranteeing less and less security for the empire. It is easiest to understand these fallacies through the prism of the behavior of private companies and states.

Companies are, unless they are bankrolled by wealthy people with endless resources, dependent upon profits to remain competitive. This profit dependence helps to focus organizational behavior: sell as many widgets for as high a price as the market will bear while keeping production costs down, and you can live another day. This same logic holds for manufacturers of Product X, both large and small, though it is nearly always better to be big for several reasons. For one thing, become large and dominant enough and gain enough market share, and you make staying in business impractical for competitors. Even better, after they cease operations you can soon amass their customers and markets, gaining momentum along the way. Size begets size.

Lord Hamilton made the mistake of extrapolating much of this same size-based logic to the seas. Whereas commercial manufacturers of like products might share similar external interests with respect to raw materials, potential consumers, markets, and the like, global navies’ interests can diverge to a much larger degree. For many navies of the 19th Century, merely protecting their share of global maritime commerce was the goal, never expansion. This is different than a truly wanton, free market security marketplace of the type that would threaten the interests of the British Empire. In other words, the navies that lagged behind the British represented states that were simply not threatening in a way that necessitated the RN doubling of the strength of its nearest competitors, much less a monopolistic control of global maritime supply lines.

This imperfect application of economic principles led to the kind of mismatch that Chandler warned against when he cautioned that structure should follow strategy. In practical terms, Hamilton also failed to consider one other important point when setting his force size. Namely, the remaining capacity of his two nearest competitors to increase production, an oversight that must have given him pause when it became apparent that France and Russia had nearly maximized their output by the end of the century, yet were still unable to match British production.

This disparity is evident in the states’ production numbers in the period following the passage of the landmark Defence Act: “1890-1900 showed England with 715,150 tons added to her naval strength, against her adversaries’ but 495,611.” Translation? Although France and Russia ramped up production in response to the RN buildup, they were still no match for British production that continued to spiral well beyond what was required to secure its maritime trade. Thus, Britain brought upon itself a situation wherein it had incentivized its competitors to ramp up materiel production out of alarm, while forcing themselves to continue to more than double the fleets of the same competitors they were forcing to expand. Precisely none of which translated into a net return on investment in terms of its overall security!

As a part of its misreading of the security environment, Britain had structured the RN as if Russia and France, non-maritime countries with diversified economic interests, were more like industry competitors fighting for a finite set of resources. In fact, these countries were preoccupied instead with the longer term German threat, as a close read of the Franco-Russian Alliance bears out. Regardless, Britain doubled down on its maritime power in an effort to support a strategy of “strength everywhere” that went well beyond what was truly required. This was a wildly inefficient course of action, as evidenced by the 155 British ships that were scrapped at the close of the period. By 1904, the year before he was appointed Foreign Secretary, Sir Edward Grey finally made the failure of the growth initiative public:

It is quite true that policy determines armaments, but armaments have also something to do with determining policy. We still have the Two-Power standard for the Navy – I think that is the official standard, that our Navy is to be equal to the Navy of any other two Powers. Yes, but the Two-Power standard does not mean what it did when it was first introduced. […] It has come to this, therefore, that while we must keep up our Navy to make us safe against any probable combination against us, yet, at the same time, with the great increase in the navies of the world, it is, in my opinion, necessary for us as a nation to depart from our old policy of splendid isolation.

More recently, modern militaries have continued to ask whether an economy of scale-esque positioning relative to its competitors is truly required to achieve strategic ends. For the U.S. in its protracted Cold War with the Soviet Union, the pursuit of such a structure was certainly in the service of its strategy of deterrence, though perhaps a true domination of the global defense landscape would have been impossible. The comparative costs imposed on the adversary were acceptable for the return they produced however, and resulted in a hastening of the USSR’s collapse under its own inefficient weight. For the individual NATO countries of that same period, the spending calculation was much different. In that particular security marketplace, banding together and pooling resources to counter a common adversary was the only feasible approach.

In areas like the Korean peninsula, the picture is murkier. To the South, a modern and efficient economy. To the North, a hermetic kingdom unwilling to advance into the 21st Century. Defense spending in South Korea is roughly six times that of its neighbor to the North, however no hypothetical economy of scale between the two countries seemingly exists that would render continued competition on the behalf of the North Koreans inadvisable. Reasons such as information asymmetry, the tacit or public backing of such partner states as China and the United States, and the upending of the “rational actor” theory of state behavior in the case of North Korea complicate matters.

Nonetheless, South Korea has continued to forge ahead anyway, announcing a 4% increase in defense spending for 2016 as a means of “deterring aggressive action” and “opening more dialogue” between the nations. Like the British before them, it remains to be seen if this financial investment will result in a corresponding increase or a decline in security. As Hamilton’s folly reminds us, the important thing when seeking to scale up to a degree unmatchable by one’s competition is that the questions of can we and should we should always be considered separate matters.

The views expressed in this blog are those of the author and do not reflect the official policy or position of the Department of the Army, Department of Defense, or the U.S. Government.